Harrods Dynamic Theory of Growth

R. F. Harrod , is a world renowned economist best known for his economic growth
model. His 'Essay in Dynamic Theory'(1939)
1
, marked the beginning of the
modern theory of growth. He extended the Keynesian static model to a dynamic
model. The purpose of this paper is to understand & analyses Harrods growth
model & the criticism that have been made of by different school of thought.
Roy F. Harrods used dynamic approach in formulating the growth of an economy
using accelerator principle and multiplier theory. The dynamic extension of the
short run Keynesian static model aims at explaining the process of equilibrium
growth in the one- sector-one- factor model of an economy. Harrods model,
through knife edge balance of the equilibrium of a growing economy concludes
that once the equilibrium of the economy disrupted the economy persistently
moves away from equilibrium violating thus the classical proposition of automatic
movement back to the equilibrium.
Two major outcomes of Harrods (1939)
2
paper were, the first definition of steady
growth rate equilibrium, and the proof of the fundamental instability of this
equilibrium resulting from the divergence between the warranted and the effective
rates of growth.
Harrod , formulated his model on the basis of three novel concepts of rates of
growth. Among them the first is the actual rate of growth indicated by g. The
second is warranted growth indicated by g
w
. And the last concept is natural rate
of growth indicated by g
n
. The g is determined by the saving propensity
indicated by s and the incremental capital output ratio indicated by K. The
warranted rate of growth i.e. the g
w
is taken to be the rate of growth required for
the full utilization of a growing stock of capital, where all saving is absorbed into
investment. And g
n
is the natural growth rate is required to maintain full
employment.
Harrod begins his argument by stating that saving is necessarily equal to
investment, which is to ex post investment. Saving is not necessarily equal to
investment in ex ante in this sense, as there might be unwanted depletion of stock
may occur.
He uses the following equation to express this relationship between the two:

1
R. F. Harrod, An Essay in Dynamic Theory, The Economic Journal, Vol. 49, No. 193 (Mar.,
1939), Blackwell Publishing for the Royal Economic Society, pp. 14-33

2
R. F. Harrod, An Essay in Dynamic Theory, The Economic Journal, Vol. 49, No. 193 (Mar.,
1939), Blackwell Publishing for the Royal Economic Society, pp. 14-33


Eq1 .

(Capitalist spend what they got)

(The Multiplier Effect)

Where P=Proffit, h=Share between Capitalist and Worker, W=wages,
C=Consumption, O=Output
Where g=actual rate of growth, Gw=warranted rate of growth, u= capacity
utilization(

)), K=Capital Stock, =Technology given capital output ratio, ,

O*=Capacity Output, I
w=
Desired Investment, s=saving propensity
According to the above two equation, Harrod postulates behavior relations with
regard to saving and investment. However like Keynes, he thinks that saving
depends on the level of income. But about the investment he thinks differently,
which not in line with Keynes. Investment is taken as autonomous (

) in the short
run and savings adjusts to it either through output or price adjustment. Another role
of investment is it determines the potential output too. For him investment depends
on the rate of increase in income. He uses the following fundamental equation to
indicate the equilibrium of steady growth. Where g
w,
is the warranted rate of
growth.
Eq2.

(Warranted Rate of Growth)

According to Harrod's, it is assumed that saving intentions are always realized.
Therefore, if there is any divergence between ex ante saving and ex ante


investment, it will take the form of unintended investment. In other words,
Harrod's fundamental equations tells us that there is only one path of economic
advance that of steady growth. In reality this may not happen.
First Knife Edge Problem
Eq3.

Harrod has also considered the implications of deviations of g (the actual rate of
growth) from g
w
(the warranted rate of growth). Let us first consider the case
when, g > g
w
. In this case the value of K will be lower than K
1
. There will then
be an undue depletion of stock or shortage of equipment. This situation will
germinate into a case of chronic inflationary gap implying that ex ante investment
will be greater than ex ante saving. Looked from a different angle it will be a case
of production falling short of aggregate demand.
If, on the contrary, g < g
w
then K will be greater than K
1
implying that there will be
superfluousness of capital goods. This situation will lead to incessant deflationary
gap, in which ex ante investment will fall short of ex ante saving.
Harrod also states that any departure of g from g
w
is unstable. It "instead of being
self-righting will be self-aggravating." Thus if g is greater than g
w
then ex ante
investment is greater than ex ante saving, and this stimulates further expansion.
If on the contrary, g is less than g
w
then ex ante investment falls short of ex ante
saving. This situation will result in unintended buildup of inventories which in turn
will depress investors so much that they will keep the rate of increase in output
below g
w
. Obviously this will have a still more depressing influence retarding
economic growth even more.
If a departure from equilibrium as would happen in all cases of g deviating from
g
w
is self-aggravating rather than self-righting, then the question arises as to how
income will stop from shooting up or down without limit. This is is first knife edge
problem.
Second Knife Edge Problem- Employment Instability
Harrod has assumed that propensity to save and capital coefficient are constant,
and thus he cannot look for an answer to the above problem in the variability of
propensity to save or capital coefficient. According to Harrod, the stimulus to
expansion in case of g being greater than g
w
will certainly not result in an unending
process. In fact, there is an upper limit to the expansion process which is set by
fundamental natural conditions such as increase in population, accumulation of
capital, technological improvement and the work/leisure preference schedule.
Eq4.

Where m=Productivity, n=Population
This limit may be characterized as the "full- employment ceiling." Obviously that
is not a fixed boundary, it will keep on changing as the basic resources grow and
technological progress happens.
Harrod calls the rise in the upper full employment ceiling the natural rate of growth
and indicates it by g
n
. There is no inherent reason for the natural rate of growth and
the warranted rate of growth to coincide. This is the second knife edge problem.
Third Knife Edge Problem-Price Instability
Harrod does not believe that there exist some unique warranted rates of growth. Its
value depends on the phase of the business cycle and the level of economic
activity. Nevertheless, one can consider that warranted rate which would be
obtained in conditions of full employment.
Harrod calls it "proper" warranted rate, but cautions that a "proper" warranted rate
higher than the natural rate will not necessarily be something good for the
economy. He asserts, "The system cannot advance more quickly than the natural
rate allows. If the proper warranted rate below its proper level and so keep its
average value over a term of years down to the natural rate.
Eq5.
But this reduction of the warranted rate is only achieved by having chronic
unemployment. The warranted rate may be pushed upwards by rising prices and
profits. If the proper warranted rate is lower than the natural rate, the average value
of the warranted rate can be sustained above its proper level for some time by a
succession of profit booms.
Harrod thus concludes that "each state of affairs has its appropriate evils." Harrod
has used his model to explain trade cycles. In the recovery phase because of the
existence of unemployed resources g > g
n
, when full employment is reached G =
g
n
. If g
w
exceeds g
n
at the full employment, slump is inevitable.
Since G had to fall below g
w
, it will, for the time being, be driven progressively
downwards. Further, G itself fluctuated during the course of the business cycle.
Savings as a fraction of income, though fairly steady in the long-run, fluctuate in
the short run.
In the short run, savings tend to be residual between the earning and normal
consumption. Companies, also, are likely to save a large portion of their short-
period increased in net receipts.


Thus, even it g
w
is normally below g
n
, it is likely to ride above g
n
in the later stages
of advance, and, if it so happens, a vicious spiral of depression is inevitable when
full employment is reached.
If g
w
does not ride above g
n
in the course of advance, there would be continued
pressure to advance when full employment is reached; this would lead to inflation
and consequently, sooner or later, to a rise of g
w
above g
n
, resulting ultimately into
a vicious spiral of depression.
Actually, G may be reduced before the employment is reached because of
immobility, frictions, and bottlenecks and, if it so happens, depression may come
before full employment is reached. If g
w
is far above g
n
, g may never rise far above
g
w
during the revival and the depression may result long before full employment is
reached.
Policy Implication
Under the assumption of constant, g increases proportionally with s. Because s is
considered to increase proportionally with income per capita, s is bound to be low
and, hence, g will be low in low-income economies if savings and investment are
left to private decision in the free market. The model implies, therefore, that the
promotion of investment by government planning and command is needed to
accelerate economic growth in low-income economies.

Criticism
As Daniele Besomi (1999, 198-215)
3
has recently documented, Roy Harrods work
on economic dynamics has been widely misinterpreted. In the economics literature
an accurate account of his contribution appears to be more the exception than the
rule. Time and again Harrod would protest against the misinterpretations, but to no
avail. The criticism came for Harrod is not from the neoclassical school (Sollow &
Swan) only but from Marxian school (Kalecki) and Keynesian School (Joan
Robinson) too.

Sollow-Swans Argument
As neoclassical growth theory is mostly based on that of the equilibrium of a
competitive economy through time. It emphasizes capital accumulation, population
growth and technical progress. It distinguishes fleeting equilibrium from long-run
equilibrium. Long-run equilibrium is not a sequence of fleeting equilibrium, as it
embodies the rational expectations of agents. The theory has very little to say about
the animal spirits that may determine an economy's potential growth rate, but

3
Besomi, Daniele. 1999. The Making of Harrods Dynamics. New York: St Martins Press.



provides a good base camp for sallies into the study of particular economies. The
Solow
4
-Swan
5
growth model is also known as the neoclassical growth model. This
is an economic model that looks into the economic growth by basing it on several
factors such as population growth and productivity. This particular model was
developed by Robert Solow.
6


Solow's model has become the standard neoclassical growth model after 1950's.
This model has a standard neoclassical assumptions, such as perfect competition
and the production function is subject to decreasing marginal return (namely when
capital is increased relative to labour, its marginal contribution to the production
will decrease). Because of the substitutions between capital and labour, market is
always in equilibrium in the sense that all the firms maximize their production
under the limitation of capital and labour, using technologies which are known to
everybody. Solow's model is a good framework to explain growth from neo-
calassical world. But it has an implication which is not compatible with the reality
of the economic growth.
Important contribution made by the neoclassical growth model of the Solow-Swan
tradition was to elucidate the decisive role of technological change in economic
growth. However, its contribution was limited because the model assumed
technological change to be given exogenously and did not attempt to incorporate
the mechanism within the economy to generate progress in technology.

The argument of the Solow-Swan growth model, as author tried to represent it,
seems straightforward enough. To understand the underlying argument, it is useful
to compare the Solow-Swan model with the Harrods model. Let us recall that the
Harrods problem exhibited two knife-edge problem i.e. the balance between the
actual and warranted rates of growth ("macroeconomic stability") and the parity
between warranted and natural rates of growth ("employment stability"). Yet the
Solow-Swan model does not address macroeconomic stability but only
employment stability.

The question of macroeconomic stability is disregarded in Solow-Swan by the
presumption that planned investment equals planned savings at all times.

4
Solow, Robert M. (1956), A Contribution to the Theory of Economic Growth, The Quarterly
Journal of Economics, Vol. 70, No. 1 (Feb., 1956), pp. 65-94

5
Swan, Trevor W. (November 1956). "Economic Growth and Capital Accumulation". Economic
Record (John Wiley & Sons) 32 (2): 334361
6
Hahn, F.H.,(2008) ,New Palgrave Dictionary of Economics, Edited by Steven N. Durlauf and
Lawrence E. Blume


The intricacies of macroeconomic adjustment, explicit theories of interest and
expectations, which were the main concerns of Harrod, are totally absent in Solow-
Swan.
Sollow has addressed the second knife edge problem. He argued that the problem
with Harrodian argument was that it assumed a rigid technologically given output-
capital ratio (). Whereas according to him, there is a continuous substitutability
between labour and capital (because of choice of techniques) which would change
this output-capital ratio itself.

By the neoclassical hypothesis of appropriation, the peripheral gainfulness of a
component will constitute the interest for that variable. In harmony, element
request equivalents calculate supply, and in this way at the business sector clearing
variable costs, Fk = r and Fl = w. In whole, we see that a neoclassical element
value alteration process is precisely what is caught by the "bend" of the escalated
handling capacity. Consequently, when we set the straight-line handling capacity
in our portrayal of the cutting edge Harrod model, the discriminating characteristic
is less that we were accepting a solitary innovation, but instead that we are not
expecting that there was an underlying neoclassical variable business clearing
process. This is the vital focus. Harrod did not accept that element costs were
determined by variable business clearing, in this way they did not join a Solow-
Swan sort of Constant Return to Scale creation capacity with adaptable
engineering. Particularly, as Roy Harrod (1948, 1953, 1973) illustrates, emulating
the Keynesian pattern, the rate of investment, r, is legislated by money related
phenomena; the true wage, well, by a variety of different things, e.g. unions, and so
on. Thus, w = w/r is not resolved by component market clearing as neoclassical
hypothesis (and Solow-Swan) accept. As Harrod did not know how (or why) the
fiscal powers, worker's guilds, firms, and so on., might change r and w with the
goal that the economy could be guided to the relentless state capital-work
proportion, he hence expected that the capital-yield degree was a steady.
Thus the neoclassical adjustment mechanism rests on two decisive assumptions:
substitution between the two factors of production, capital and labour, and
flexibility of factor prices.

The basic conclusion of this analysis is that, when production takes place under the
usual neoclassical conditions of variable proportions and constant returns to scale,
no simple opposition between natural and warranted rates of growth is possible.
There may not be in fact in the case of the Cobb-Douglas function there never can
be any knife-edge problem. The system can adjust to any given rate of growth of


the labour force, and eventually approach a state of steady proportional expansion.
7


Seen in this light, it is difficult to acknowledge the common abstain that Solow-
Swan "generalized" the Harrod model just because they allowed for flexible
technology whereas Harrod did not. This is certainly what Solow insinuated,
arguing that the "bulk of this paper is devoted to a model of long-run growth which
accepts all the Harrod assumptions except that of fixed proportions." (Solow, 1956:
p.66). But, as this discussion has hopefully made clear, it is not technology that is
critically different. It is the adjustment process.
It might possibly be contended, that the Harrod model is "more general"
thanSolow-Swan. Harrod make fewer prohibitive assumptions. Firstly, they do not
presume an momentarily stable macroeconomic equilibrium (as Solow-Swan do).
Further more, they do not assume any particular factor price adjustment
mechanism (as Solow-Swan do).
However, as we shall see, it turns out that Solow-Swan performs poorly when
confronted with empirical evidence. Substantial modifications have to be added
(particularly regarding technical progress) to make it comply with the data.
Interestingly, the kind of modifications to the Solow-Swan growth model that
"endogenous growth theory" has proposed in recent years turn out to generate a
reduced-form dynamical system that is virtually identical to the Harrod model.
Taking an analogy from astronomy, economists have had to add epicycles upon
epicycles upon epicycles to the Solowian growth model in order to have it explain
what could be more simply explained by the Harrod model. The conclusion
imposes itself.
Finally, we should remind ourselves why Solow-Swan is a "neoclassical" and not a
"Keynesian" growth model. From the outset, we have a very neoclassical factor
market equilibrium adjustment process. But, perhaps more strikingly, the
macroeconomics are very different. A complete Keynesian growth model would
have investment as a function of financial conditions and savings derived from
investment via the multiplier. In the Solow-Swan model, not only are all
Keynesian "financial" factors omitted, but the direction of causality between
savings and investment is reversed. This is equivalent to re-imposing Say's Law.
Thus, the Solow-Swan growth model is "neoclassical" in every respect, and not an
extension of "Keynesian" macroeconomics, as has occasionally been advertised.



7
Solow, Robert M. (1956), A Contribution to the Theory of Economic Growth, The Quarterly
Journal of Economics, Vol. 70, No. 1 (Feb., 1956), pp. 65-94


Kaleckis Argument

Michal Kalecki is one of the most productive economists of his generation, he was
nonetheless largely self-taught in economics. While Kalecki's theoretical
framework came essentially from Marx, his application and development of
concepts was the result of observation of economic life around him, and
consideration of data.
8

Kalecki
9
in his paper argued that Harrod failed to take his instability theory to its
logical conclusion. According to him not only is the warranted rate unstable, no
growth rate except a zero rate of growth is stable for a capitalist economy in the
absence of any exogenous stimuli.
Kalecki's central concern was the analysis of how in capitalism business cycles and
long term growth are generated; and that he first presented his theory of effective
demand in the context of a model of cyclical growth. Kalecki developed a model in
which there exists a continual movement through a series of short-period equilibria
or quasi-equilibria. Moreover, this movement will be cyclical and any position of
final equilibrium will never be reached, because business fluctuations will
permanently take place. Kalecki also assumed that the expansion of demand is, not
only a necessary condition for growth in the long term, but in addition a sufficient
condition. More precisely, Kaleckis long-run theory of effective demand was a
long-run theory of investment decisions.
Kaleckian models are characterized by a low sensitivity of accumulation to
variations in utilization and the treatment of utilization as an accommodating
variable in both the short and the long-run. Thus, the steady growth value of the
utilization rate is not, as in Harrodian models, tied to a structurally determined
desired rate. Instead, shocks to demand (changes in saving rates, for instance) can
have large, permanent effects on utilization.
One important factor which Kalecki implicitly supposes that the level of effective
economic activity is always below the potential level; which is to say that, in every
moment of time there exists unutilized productive capacity. Kalecki specifies this
when he states that a laissez faire capitalist economy used to achieve a more or
less full utilization of resources only at the top of a boom, and frequently not even
then (Kalecki, 1968b, p. 438). This is for competitive reasons. Even in situations
of oligopoly where competition is limited, firms fear new entrants, prepare for new
products. For these reasons, they would attempt to keep some idle capacity as a

8
Ghosh, Jayati, (2011), Michal Kalecki and the Economics of Development,
9
Kalecki, M., (1962) , Observations on the Theory of Growth, The Economic Journal, Vol. 72,
No. 285), pp. 134-153


contingency. Steindl
10
had argued that this is akin to Keynes' liquidity preference
theory. Hence, instead of attempting to exhaust full capacity they desire to
underutilize it like, u
0
> 1. So this investment function become

] instead of

].

For Kalecki, then dynamic analysis of capitalist economies was essentially
disequilibrium analysis of business cycles. The trend emerged as a result of the
path of the cycle. As a result, Kalecki dismissed the notion of equilibrium growth
as being operationally insignificant. In addition, he saw strong stagnationist
tendencies in capitalist economies, which meant that the trend would be around a
static position, unless exogenous and semi-exogenous forces, such as innovation,
were to play a role.
But Kaleckis argument about stagnation in capitalism is bit problematic as it has a
positive rate of growth. Hence the argument against Kalecki by Keynesian is that,
Capitalist state has played the role of a price as well as output stabilizer. Similarly,
state should play the role of providing impetus to growth and development in the
Third World. And by Marxian is that, the Periphery of the Third World has played
the role of both output and price stabilizer for the capitalist core. And precisely for
this reason, diffusion of capital has not and, more importantly, cannot happen in
the periphery.











10
Steindl, J. (1981), Some Comments on the Three Versions of Kaleckis Theory of the Trade
Cycle. Reprinted in M. Kalecki, Collected Works, vol. I, Oxford: Clarendon Press, 1990.







Harrodian knife-edge instability is a result of an
artificially restrictive assumption of a rigid output-
capital ratio. Once that is removed, capitalism
becomes inherently stable.

Term Paper of Growth & Technical Progress




Submitted To:
Asst. Prof. Rohit
Centre for Economic Studies & Planning
School of Social Sciences





Submitted By:
Naresh Chandra Mallik
M. Phil (II
nd
Semester)
nareshmallik@gmail.com